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Tax Law

Transfer Pricing and International Taxation: A Continuing Problem for Taxing Authorities

by Mary Riley *

It is a general maxim that taxpayers want to minimize their tax liability to the greatest extent possible. However, taxpayers who overzealously pursue this aim risk crossing the line separating permissible tax avoidance from impermissible tax evasion. In the realm of international business tax law, nowhere is this issue more pressing than in the arena of transfer pricing, in cases where the taxpayer is a multi-national enterprise (MNE) comprised of corporate entities located in several tax jurisdictions worldwide. While transfer pricing, in and of itself, is not an unlawful activity, the abuses associated with transfer pricing in recent years have tainted that term, making it synonymous with nefarious activity: tax dodging, corporate greed and social irresponsibility of MNEs, and often rendering legal distinction between tax avoidance and tax evasion superfluous. [Jasmine M. Fisher, "Fairer Shores: Tax Havens, Tax Avoidance, and Corporate Social Responsibility," Boston University Law Review, Vol. 94:337-365 (2014) [hereinafter referred to as "Corporate Social Responsibility"]].

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What Is Transfer Pricing?

Transfer pricing is a profit allocation method used to attribute an MNE's net income (profit or loss) to the tax jurisdictions where it operates its subsidiary controlled foreign corporations (CFCs). The transfer price is defined as the price charged between related corporate entities for goods or services in an intercompany transaction. [John McKinley and John Owsley, "Transfer Pricing and Its Effect on Financial Reporting. Multinational companies face high-risk tax accounting," Journal of Accountancy, October 2013 [hereinafter referred to as "Transfer Pricing and Financial Reporting"], available at http://www.journalofaccountancy.com/Issues/2013/Oct/20137721.htm.] Within the MNE, each corporate entity generates its own profit and, ideally, interacts with related corporate entities on an arm's length basis, as though the transactions were occurring between unrelated parties on the general market. [Barron's Dictionary of Business Terms, 4th ed., Barron's Educational Series, Inc. (2007), p. 686.] Under federal tax law, although intercompany transactions are eliminated when consolidating the financial results of CFCs and their domestic parents, for tax purposes CFCs are not consolidated and thus the intercompany transactions are not eliminated. [26 USC § 1504(b)(3); see, McKinley and Owsley, Transfer Pricing and Financial Reporting, (supra).] (That is, the income result for each corporate entity is still separately reported, even if the all of the income is consolidated and reported on one tax return). Accordingly, each CFC is subject to the tax laws governing the jurisdiction in which it is located.

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Abuses in Transfer Pricing Strategies

Abuses arise when the MNE taxpayer uses transfer pricing to shift income to low or no tax jurisdictions, typically by adding steps to an intercompany transaction such that most of the profit is made in a low (or no) income tax jurisdiction. [Kenneth Klassen, Petro Lisowsky, and Devan Mescall, "Transfer Pricing: Strategies, Practices, and Tax Minimization," p. 1 (April 29, 2013), available at SSRN: http://ssrn.com/abstract=2216870 or http://dx.doi.org/10.2139/ssrn.2216870.] The added steps have no bearing on the economic substance of the transaction; the sole purpose for adding the steps is for tax avoidance...

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Internal Revenue Code Section 482 and Tax Havens

Federal tax law provides that the Secretary of the Treasury has the discretion to reallocate the income from intercompany transactions in order to prevent tax evasion or to clearly reflect the income of the parties, using the arm's length transaction is the standard. [26 USC § 1504(b)(3); 26 CFR § 1.482-1(a)(1).] While Section 482 and the corresponding federal regulations may reallocate income when an MNE sets the transfer price too high (or too low) in an intercompany transaction, it provides no protection against the use of tax havens to minimize tax liabilities. [Fisher, Corporate Social Responsibility, at 342-344.] As a result, the IRS estimates that there may be a "tax gap" as high as $345 billion based on improper transfer pricing strategies resulting in tax avoidance and evasion. [Brian Tully, "Transfer Pricing Strategies and the Impact on Organizations," Financial Executive, July/August 2012 [hereinafter referred to as Transfer Pricing Strategies]. Available online at http://www.financialexecutives.org/KenticoCMS/Financial-Executive-Magazine/2012_07/Transfer-Pricing-Strategies-and-the-Impact-on-Orga.aspx.]

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The Public Response

... Reports of tax avoidance by MNEs generating billions in revenue each year worldwide, while leaving ordinary citizens and small businesses to make up the lost tax revenues domestically, has led to increasing public anger over transfer price abuses and has initiated larger discussions about corporate social responsibility. Further, the legal distinction between lawful tax avoidance and unlawful tax evasion largely lost on a global public that is outraged to learn that MNEs are not paying their apparent fair share of income tax to local taxing authorities. [Fisher, Corporate Social Responsibility, pp. 339-346.]

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The Response by Local Taxing Authorities

Local tax authorities have responded by focusing increased attention on transfer pricing transactions and holding them to higher levels of scrutiny. [See, eg, White Paper on Transfer Pricing Documentation, 30 July 2013, Organisation for Economic Cooperation and Development (OECD), available online at http://www.oecd.org/.] For example, Hong Kong has only recently developed a transfer pricing regime, including the use of Advanced Pricing Agreements (APAs), and began conducting transfer pricing audits of corporate taxpayers in 2012. [I-Ching Ng, "Top Tips: Hong Kong's New Transfer Pricing Regime", The Corporate Treasurer (June 24, 2013), available online at http://www.thecorporatetreasurer.com/News/347758,top-tips-hong-kong8217s-new-transfer-pricing-regime.aspx.]...

At the time of this writing, MNEs must devote more resources, time, and expense to monitor the rapidly changing international tax landscape, with regard to transfer pricing rules, in order to minimize the risk of incurring tax penalties. In turn, tax authorities have and will continue to allocate more resources, time and expense to reviewing transfer pricing transactions in an effort to halt tax avoidance and evasion, which erode the corporate tax base. The only thing that is certain is that it will be a long time before there is any certainty, clarity, or predictability in this area of international tax law.

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* Mary Riley is a member of the bar in South Carolina and Illinois. A former associate attorney at Merritt, Flebotte, Wilson, Webb & Caruso, PLLC, a general practice law firm in Columbia, South Carolina, she has extensive experience analyzing legal issues in federal and state taxation. Ms. Riley earned her B.A. in anthropology from Beloit College, her M.A. and Ph.D. in cultural anthropology from Tulane University, and her J.D. from Northern Illinois University.

Information referenced herein is provided for educational purposes only. For legal advice applicable to the facts of your particular situation, you should obtain the services of a qualified attorney licensed to practice law in your state.

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